3 tricky rules for personal trusts

Personal trusts are a staple of estate planning, but in order to use them to your advantage, there are three important rules you need to know.

• When capital gains/losses generated by trust property must be recognized.
• How long income may be accumulated in a trust.
• How long a trust may last (“rule against perpetuities”).

The first, known as the 21-year deemed disposition rule, is federal law that applies to all trusts resident in Canada. The rules against accumulations and perpetuities originated in common law and apply differently across the country.

1. The 21-year rule

This rule curtails a person’s ability to transfer property tax-free from generation to generation. It applies to certain types of property held by a trust, not to trusts generally. It’s also important to note the deemed disposition does not necessarily occur at 21-year intervals and, depending on the circumstances, other deemed disposition and reacquisition rules may apply.

Both inter vivos and testamentary trusts are generally deemed to dispose, at periodic times, of certain types of property for proceeds equal to fair market value, and to immediately thereafter reacquire the properties at a cost equal to that value. This means trusts may be required to realize and pay tax on capital gains without actually receiving the proceeds of disposition.

With careful planning, application of the 21-year rule can generally be avoided. This is normally done by ensuring the terms of the trust allow trust property to be distributed to a Canadian-resident capital beneficiary before the deadline.

2. Rule against accumulations

This common-law rule prohibits adding income or interest earned by a trust back into the capital of the trust fund beyond a certain time period. Many provinces have since abolished this rule, but it remains in force in Ontario and Newfoundland and Labrador.

Here’s an example of how the rule works. Jane’s will creates trusts for her grandchildren with instructions to hold the funds so no payments are made until a grandchild is age 25. Granddaughter Lisa is 2 years old at the time of Jane’s death, so her share will be held in trust for 23 years. Pursuant to Ontario’s Accumulations Act, the income generated by the trust property can be added back to the trust for 21 years only. Beginning in year 22, the trustee may no longer accumulate this income, but must instead pay it to Lisa.

3. Rule against perpetuities

The rule against perpetuities is complicated and often misunderstood.

The rule states that an interest in a trust must vest within a particular period. This means the beneficiary must become entitled to the property within that timeframe. The time period specified was “no later than 21 years after the death of a ‘life in being’ [the remaining duration of the life of a person alive at the time the trust deed or will takes effect]” when the interest was created. Common law says the interest is void if there was any chance it might vest outside this period.

The concept of a life in being can be confusing, as can the concept of vesting. It’s easy for a drafting lawyer to inadvertently breach the rule and for a trustee to misinterpret the rule. As a result, the rule has been abolished in a few provinces, including Saskatchewan, Manitoba and Nova Scotia. Others have simplified it and introduced a different time period for vesting (80 years in B.C., 60 in P.E.I.). This common law concept doesn’t exist in Quebec; however, the Civil Code does have certain restrictions related to time and rank of beneficiary.

Ontario’s Perpetuities Act keeps the 21-year measure, but establishes a wait-and-see approach. Instead of deeming an interest void if it might possibly vest outside this period, interests are presumed valid until actual events establish the interest cannot vest within the perpetuity period.

Importance of sound planning

Failure to address the deemed disposition rule could result in adverse tax consequences, while failure to address either or both of the rules against perpetuities and accumulations could result in a plan that fails to deliver on the testator’s intentions. Costly legal opinions and court applications may also result.

Beyond knowing these rules, your best options is to work with specialists. This will help ensure you get a plan that addresses your goals, delivering peace of mind.